Below is my email interview with Craig Israelsen, professor and author of 7Twelve: A Diversified Investment Portfolio with a Plan*, a book about an interesting portfolio (explained in the interview) idea.
First off, what is the 7Twelve Portfolio?
The “7Twelve” is a diversified, balanced portfolio that contains 7 core asset classes and 12 underlying “sub-asset” investments—hence the name 7Twelve. The 7 core asset classes include US stocks, non-US stocks, real estate, resources, US bonds, non-US bonds, and cash. The 12 underlying investments can be mutual funds and/or exchange traded funds. Each of the 12 underlying investments has an equally-weighted allocation of 8.33%. The overall asset mix is 67% equity and 33% fixed income (or roughly a 65/35 asset allocation).
There are 3 underlying sub-asset (or investments) in the “US stock” asset class: large cap US stock, mid-cap US stock, and small cap US stock. The two underlying sub-assets in the non-US stock asset class are developed non-US stock and emerging non-US stock. There is one sub-asset in real asset which is a global real estate fund. In the resources category there are two sub-assets: natural resources and commodities. Within the US bond asset class are two investments: aggregate US bonds and inflation protected bonds. Non-US bonds has one underlying non-US bond mutual fund. Finally, there is an 8.33% allocation to cash. The 12 sub-assets are rebalanced periodically back to 8.33% of the overall portfolio.
How did you first come up with the idea for the portfolio?
The genesis of the 7Twelve portfolio has really been my mutual fund research and writing for the past 20 years. More specifically, the 7Twelve portfolio was the outgrowth of a December 2007 article I published in the Journal of Indexes. The article was entitled “The Benefits of Low Correlation”. That article described the risk-adjusted performance of building a multi-asset portfolio that utilized seven asset classes: US large stock, US small stock, non-US stock, real estate, commodities, US bonds, and cash. The data period of that study was from 1970-2006.
In your opinion, what are the advantages of the 7 Twelve Portfolio over other strategies?
The 7Twelve is a strategic blueprint for building and managing the core component in virtually any investment portfolio. By strategic I mean that that it is a portfolio recipe that doesn’t change based on emotion or market “noise”. It is an investing plan that is stable and enduring—as the core of an investment portfolio should be. Too many investing strategies cannot articulate a clear plan of the portfolio design. Moreover, far too many portfolios are not sufficiently diversified. For example, the typical “balanced” fund has only two major asset exposures: US stock and US bonds. The 7Twelve portfolio resolves both of these shortcomings.
Are there any disadvantages of the 7 Twelve Portfolio?
Sure, it’s not very exciting. It’s an equally weighted, multi-asset portfolio that is rebalanced periodically. It is simple and straight-forward and completely transparent. Not really the worst disadvantage in the world!
When I first read about your strategy, you only used seven securities for the portfolio. I noticed you changed the strategy to include twelve securities. Why the change?
The original research you saw was the Journal of Indexes article back in December of 2007 (article here). I used 7 asset classes in that research because I was interested in studying a multi-asset portfolio for as many years as possible (given the constraints of available performance data). I was able to study the performance of that original 7 asset portfolio back to 1970. The 7Twelve portfolio expanded the underlying investments from 7 to 12 because I wanted to create a portfolio that was more “granular”. For example, the number of fixed income investments expanded from two to four and the equity (and equity-like) assets expanded from five to eight. So, it wasn’t a change, it was an evolution toward even more diversification.
I know you had to use back testing in your book. How did the portfolio perform over the last decade (2000 – 2009) as compared to the S&P 500 Index or even a 60/40 (stocks/bonds) portfolio? It appears that commodities, which represent nearly 17% of the portfolio, helped significantly in the portfolio’s return. Any fear that commodities could be a drag on future returns?
Yes, historical performance measurement is vital. But, and this is a really important point, back-testing is only valid if the rules of the game are objective. The 7Twelve portfolio uses clear rules (equal weighting and periodic rebalancing). Thus, the back-tests are not an exercise in “cherry-picking” funds that performed well after-the-fact.
The 10-year average annualized return from January 1, 2000 to December 31, 2009 of the ETF-based 7Twelve portfolio (which is referred to as the Passive 7Twelve) was 7.5%. The typical 60% stock/40% “balanced” portfolio had a 10-year return of about 2.6%. The S&P 500 had a 10-year average annualized return of -1.0% from 2000-2009.
Interesting observation about commodities. It’s true that the commodities “ingredient” in the 7Twelve model had a strong average annual return of 14.5% the 10-year period from 2000 through 2009. The other sub-asset in the 7Twelve portfolio’s “Resources” asset category was a natural resources fund which a 10-year average annualized return of 8.7%. While these were certainly helpful to the overall 7Twelve portfolio, there were other sub-assets that were strong contributors such as small cap US stock, non-US emerging stock, real estate, and TIPS (treasury inflation protected bonds). Going forward it’s possible that any of the portfolio’s 12 ingredients could be a drag on performance. That’s the beauty of having a broadly diversified portfolio: if one or two (or more in 2008) have a bad stretch of performance it’s anticipated that some of the other portfolio ingredients will have a good run.
Your current portfolio allocates 33% to fixed income and cash. Is that a little too conservative for younger investors? Does your strategy allow for individual adjustments?
It may be more conservative than some other portfolios in terms of the fixed income component. However, consider that it’s a diversified fixed income “bucket” that includes non-US bonds which tend to have more volatility of return than US bonds. For an investor that follows the “your age in bonds” guideline a 25-year old should be 75% equity and 25% fixed income. Thus, the 7Twelve fixed income allocation of 33% is a higher fixed income allocation for a 25-year old, but right on target for a 35-year old. As an investor ages, they may choose to to “overweight” their allocations in TIPS and cash. I’ve designed several “Life Stage 7Twelve” portfolios that do exactly that.
In your book, 7Twelve: A Diversified Investment Portfolio with a Plan*, you list several mutual funds and exchange-traded funds that can be used in constructing a portfolio. Which do you prefer: mutual funds or exchange-traded funds?
Both are perfectly suited for use in the 7Twelve portfolio. The advantage of ETF’s is that they are pure exposure to an asset. In other words, when you invest in SPY (an ETF that tracks the S&P 500 Index) you have pure exposure to the S&P 500 Index. There are no other asset classes in SPY–no bonds, no cash, no non-US stock, etc. Whereas an actively managed mutual fund that more or less tracks the S&P 500 Index will often contain some cash, perhaps a small allocation to bonds, and maybe a few international stocks. While that actively managed fund might be a great fund, it’s not a pure asset exposure. Of course, index-based mutual funds solve that problem. Therefore, index-based mutual funds and/or exchange traded funds are ideal ingredients in the 7Twelve portfolio. If an investor wants to use actively managed funds in the 7Twelve portfolio, that’s perfectly fine. They just need to be prepared for the potential of style drift and possible asset allocation drift.
What is your recommendation for how frequently the portfolio should be rebalanced? Monthly? Annually?
Annual rebalancing tends to produce the best results. For instance, as already noted the 10-year average annualized return of the ETF-based 7Twelve portfolio from 2000-2009 was 7.5% (assuming monthly rebalancing). If the portfolio was rebalanced annually the 10-year return was 7.8%. Not a huge difference, but since rebalancing less often also helps tax-efficiency (and requires less work) it’s the way to go. Less is more.
Finally, in your book, you also show different strategies of using the 7 Twelve Portfolio with additional fixed income for retirees. Is this really necessary given that the portfolio already has 33% allocated to bonds?
Yes, the Life Stage versions of the 7Twelve portfolio are a prudent way to protect older investors from large losses when they can least afford to experience them—when they are near retirement or in retirement. For instance, the return in 2008 of the Life Stage 70+ 7Twelve portfolio (designed for investors at or beyond the age of 70) was -9.2% if using annual rebalancing. By comparison, the typical 60/40 balanced fund had a return of about -21% in 2008. Even worse, the S&P 500 Index had a return of -37% in 2008.
I want to thank Dr. Israelsen for his time. This was a great interview and I hope it was helpful to AFM readers.